Developments over the past month have sent jitters through the international banking community. Three banks in the US were closed and the task of resolution is still incomplete. The first to go was Silvergate, on March 8, but its closure did not invite much attention. But when within a week Silicon Valley Bank (SVB) and Signature Bank also shut down, marking the second and third largest banking failures in US history after the failure of Washington Mutual, the trend set off panic.
No longer could bank failures be dismissed as exceptional and attributed to, say, operational shortfalls or rogue bankers. These failures seemed to be symptomatic of systemic tendencies that could affect the solvency of the financial system as a whole and have anadverse fallout for the real economy.
Advanced economies that have not yet managed to ensure a sustained recovery from the Great Recession that followed the 2008 global financial crisis are once again under threat.
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Evidence in support of this conjecture is not hard to find. For instance, the stock price of First Republic, an important US bank, collapsed from $115-120 a share in early March to around $12 in late March.
The Federal Reserve stepped in and other big banks that could be the victims of contagion provided a helping hand. The rescue effort involved a liquidity infusion of $70 billion, of which $30 billion came from the 11 largest US banks and the remaining $40 billion from a Fed lending facility.
Impact in Europe
The factors affecting the stability of US banks seemed to be playing a role in Europe as well. Credit Suisse, which had been incurring losses in its investment banking operations and elsewhere, seemed to be the weak link despite being the 30th largest systemically important bank in the world.
The losses it was suffering could not be matched by mobilisation of new capital owing to investor reluctance. A 50-billion-Swiss franc backstop from the Swiss National Bank (SNB) did not help either. So, the bank had to exit life as an independent entity, and was forced by the SNB to merge with its already large competitor, UBS.
This merger was humiliating for Credit Suisse stakeholders. UBS’ initial offer was just around $1 billion when its market cap was around $8 billion.
That did not go through, but the final price UBS paid was only 0.76 francs, compared with the Credit Suisse share price of 7.26 francs on March 29, 2022.
These signs of big bank fragility raise fears of a return to the global financial crisis of 2008, which can be devastating since governments have exhausted many of the options they had at that time to stall the real-economy collapse that followed.
The SVB collapse tells a larger story. The proximate cause of that failure was an inability to meet depositor demands for withdrawal by selling available assets or mobilising new capital. This turn of fate was unexpected, given SVB’s business model. It was no ordinary bank that accepted small deposits from risk-averse savers. It mobilised its funds from wealthy individuals, and more importantly, from start-ups flush with funds needed to meet their expenditure until returns from promising ideas turned positive.
That is, start-up deposits were, by definition, meant to be withdrawn to cover expenses. These funds had, in turn, been received by the start-ups from speculative financiers incarnated as private equity investors and venture capital funds.
With the US Federal Reserve and other advanced economy central banks having adopted unconventional monetary policies, involving quantitative easing and low or near-zero interest rates, in response to the 2008 crisis, the world was awash with cheap liquidity.
Riding on those funds, Global Finance had become used to investing in risky ventures in search of high yields. A consequence was a start-up boom with funds for new entities and repeated rounds of funding for existing ones with inflated valuations.
The start-ups needed to hold these funds for use over time, and banks like SVB were ready to serve as locations for parking such funds, with targeted services and special privileges for such bulk depositors. Withdrawals were expected to be smooth and predictable.
SVB, which reportedly was banker to around half of the US venture-backed tech and life sciences firms, saw its deposit base surge during the ‘tech boom’ of 2022, from $102 billion to $189 billion. Being successful in attracting these deposits, which were in principle sources of short-maturity capital, SVB needed a business model that could ensure good returns (which normally meant longer maturities and a degree of illiquidity) without running into liquidity problems.
SVB’s business model
It seemingly found such a model, which consisted of making large investments in securities that were considered safe or relatively safe and diverting the rest of its capital to loans made to private equity firms and venture capital funds, which were the original sources of this capital in circulation.
Beguiled by the large funds it was receiving, SVB was willing to trade liquidity possibly for better returns. Securities are of two kinds: “available for sale” securities and “held to maturity” (HTM) securities that are not marked-to-market. That implies that if the prices of the latter bonds fall in the market, the implicit losses being incurred are not recorded in the accounts of the institution.
At the end of 2022, SVB held $26 billion of “available for sale” securities, mainly US Treasuries. Another $91 billion of its securities portfolio consisted of agency backed mortgage-backed securities, which were seen as relatively safe. The remaining funds were provided as loans (the quantum placed at upwards of $70 billion) to private equity firms and venture capital funds.
This seemed to be a safe and profitable business model. Although the deposits made by start-ups in banks like SVB were meant to be spent, there was no fear of the demand for withdrawals exceeding available liquid funds. And the funds with the bank were being deployed in a safe portfolio offering reasonable returns.
What was missed was that this model depended on an environment where liquidity was ample and interest rates low. And that, in turn, depended on inflation running at low rates, failing which orthodox monetary policymakers would find the need to raise interest rates to rein in inflation, even if price increases were rising because of cost increases.
Western capitalism had, over the past three decades, become used to the so-called “new normal” of low inflation, which came to be identified as the Great Moderation. When value chains were disrupted by the COVID-19 pandemic and commodity prices rose because of speculation, growth was still subdued. When the restrictions on economic activity began to be relaxed, the recovery fuelled further price increases in advanced nations as well.
- Three banks in the US were closed and the task of resolution is still incomplete. Advanced economies that have not recovered from the Great Recession after the 2008 global financial crisis are once again under threat.
- The bank rescue involved a liquidity infusion of $70 billion, of which $30 billion came from the 11 largest US banks and $40 billion from a Fed lending facility.
- The factors affecting US banks played a role in Europe too. Credit Suisse, despite being the 30th largest systemically important bank in the world, was forced by the Swiss central bank, to merge with UBS.
- These signs of big bank fragility raise fears of a return to the global financial crisis of 2008.
Tightening money supply
The US Fed and central banks in Europe and elsewhere responded to this by raising interest rates. In the US, interest rates have risen from about 0.25-0.5 per cent to 4.5-5.0 per cent. There were also signs of a turn from quantitative easing to quantitative restrictions on money supply, signalling the beginning of the end of the easy money era.
This had many consequences. First, the flow of capital to start-ups with still uncertain economic futures shrank and sometimes even froze, forcing them to empty their deposits held in banks to finance their spending needs that were not matched with revenues.
Second, there was little money for new start-ups with talk of a financing famine. This soon meant that SVB was faced with a liquidity crunch, requiring it to unwind assets to meet depositor demands for withdrawals. With much money held in HTM securities, that was a problem.
Third, the rise in interest rates had their expected effect of bringing down bond prices, so the sale of securities would have to be at a loss, and some HTM securities had to be sold in advance as well.
At the end of 2022, securities on SVB’s balance sheet that were valued at $91 billion at their purchase prices were worth only $76 billion, pointing to an implicit loss of $15 billion. The actual sale of $21 billion of securities to meet demands from depositors resulted in a loss of $1.8 billion.
Fourth, sensing the difficulties faced by SVB, the market also drove down its share price. The bank’s market capitalisation, which doubled between 2018 and 2021, fell to $17 billion in February 2023. So, when the bank decided to raise $2.25 billion in new funding through equity sales to cover losses on bond sales, the effort failed.
As news got around that SVB was faced with insolvency, withdrawals were no more restricted to sums needed to finance start-up expenditure. Bulk depositors thought it safe to withdraw their money and park it elsewhere for safety, and private equity investors and venture capitalists advised them to do just that. The result was a run on the bank, with $42 billion withdrawn in one day. This only worsened matters.
Sensing that this was not a one-off event but one that portended a systemic crisis, the Fed and the government got into panic mode. The first objective seems to have been to protect depositors to stall the run.
The problem here, of course, was that the deposit insurance system was always designed to protect small depositors, with ceilings on the amount insured. Currently, that stands at $250,000. But given the nature of SVB’s business model and that of its depositors, at the end of 2022, 96 per cent of the $173.1 billion of deposits that it held were not covered.
In an unusual response, the US government declared that given the systemic dangers associated with a possible turn to insolvency of SVB, and the impact that this might have on the start-up universe, it had decided to protect all depositors in the institution. That went against all norms associated with deposit insurance, which was meant to protect ordinary, smaller depositors, and against the principles that the US has preached on the need to allow market to work and discipline “rogue” operators.
But the issue was clearly not start-ups. This became clear when the US Fed declared that all banks facing losses from selling bonds at a loss following the rise in interest rates would be protected in some form.
Principally, they would be treated as systemic risk exceptions and have access to a discount window to borrow against those bonds valued at par. According to one quick estimate, the overall losses suffered by the US banking system on account of bondholding stood at about $600 billion by the end of 2022. That was being transferred to the Fed. It was clear here that the rules prescribed for others by the Fed can be dropped when needed in the US.
This sense of panic when it came to resolving the problem was visible even when Credit Suisse, which had already been in trouble, faced the consequences of the decision of central banks to raise interest rates and bondholdings lost value.
As ‘safe capital’, Credit Suisse had on its books $17.3 billion of Contingent Convertible Bonds, which had no definite maturity but could take a hit when banks ran into trouble.
But when the message went out that the global environment was one where interest rates were on the rise, those bonds lost value. That only added to the damaging effects of the multiple errors the bank had made earlier, leading to the threat of insolvency.
The stress forced the Swiss central bank to intervene. When a liquidity backstop did not help, the SNB worked to force a merger of Credit Suisse with UBS. But UBS was given major concessions to agree. All Additional Tier 1 bonds issued by Credit Suisse, introduced after the 2008 crisis to shore up capital by means other than equity, were written down.
In principle, these bonds are meant to be senior to equity, and when their value falls to a certain level they are to be converted into equity and holders paid the same as shareholders at liquidation. But when Credit Suisse was absorbed into UBS, share values were still positive, but using a clause in the fine print the AT1 bonds were fully written down.
As in the case of the US, when the state sensed a crisis, all rules could be broken.
The early responses to banking fragility point to the perception in government and central bank circles that this could be another 2008. But managing a crisis is bound to be even more difficult this time.
Immediately, there is the threat of a global dollar shortage. Lending borrowed dollars is a practice adopted by banks overseas as well, and if there is an unanticipated demand for dollar withdrawals, neither they nor their governments can provide the needed backstop in a foreign currency.
Moreover, with the Fed conveying the impression that it would protect all depositors when banks fail, not just those with deposits of $250,000 or less, depositors are likely to shift to the US in a flight to safety.
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A severe global dollar shortage with multiple consequences is a real possibility. This is also indicated by the Fed’s decision to organise dollar swaps for foreign currencies with other central banks every day, as opposed to the practice of doing so every week. Partner central banks acquire dollars in exchange for their own currency and pay the Fed interest. The Fed’s tap is being opened not just for resident players but globally.
Meanwhile, the developing scenario has challenged the prevailing central bank orthodoxy that the only instruments to use when fighting inflation are raising interest rates and tightening money supply. Neither seems possible now without aggravating the crisis. But inflation remains a real and present threat.
Capitalism seems to have lost all its moorings.
C.P. Chandrasekhar taught for more than three decades at the Centre for Economic Studies and Planning, Jawaharlal Nehru University, New Delhi. He is currently Senior Research Fellow at the Political Economy Research Institute, University of Massachusetts Amherst, US.